Wage Inflation? Forget About It

Commentary by Bob McTeer

April 30, 2014

Source: Forbes

“Economists, all or most of us consent

If wage rates rise by 10 percent

It puts the choice before the nation

Of unemployment or inflation.”

I learned that little rhyme in undergraduate money and banking class from Professor James Waller. As I recall, he gave credit for it to a friend of his, probably from the University of North Carolina. Sorry, but I’ve forgotten exactly who that was, but, if I had to guess, I’d guess Clarence Philbrook.

The lessons of the rhyme were that higher wages don’t cause inflation by themselves, that inflation is a monetary phenomenon, but that rising wages might trigger sufficient monetary expansion to turn the higher wages into generalized inflation, but that, if monetary expansion wasn’t forthcoming, the main effect of substantially higher wages (10% in the rhyme) would be higher unemployment. It was a monetarist rhyme that was intended to debunk the idea of “cost push inflation” or “wage inflation.” The monetary expansion that might support a rise in inflation would not be triggered by rising wages per se, but would be to offset the incipient unemployment growing out of higher wages without monetary expansion. The Fed would be fighting the unemployment rather than the higher wages.

All this came back to me this morning listening to CNBC hosts and guests go on and on about wage inflation. How much wage inflation would Janet Yellen tolerate before pulling the monetary plug? As far as I can tell—and I served on the FOMC with her for about three years—Janet Yellen is not a monetarist, but she probably doesn’t believe in cost push inflation either. She would likely take a traditional economist view that wages are caused by supply and demand for labor and that behind the demand curve would be the marginal revenue that the next unit of labor employed would add. Behind that is the productivity of labor, defined as output per unit of input, or output per hour worked. She likely has noticed the recent decline in the productivity of labor, which is a factor limiting demand.

Even though productivity is called the productivity of labor, the amount of capital per worker is the main determinant of the productivity of labor. Productivity usually has more to do with those evil capitalists than those virtuous workers. In this context, today’s GDP weakness is telling. GDP growth didn’t fall because of consumer spending, but because of a chronic lack of business fixed investment (non-residential) spending.

In any case, a rise in wages would be a healthy development, not one to be dreaded. Higher wages would reflect higher productivity relative to the supply of labor and would only be inflationary generally if it triggers massive monetary expansion. But massive monetary expansion would be inflationary no matter what happens to wages.